Interest Rates

Why Interest Rates Change

Interest rates are bound to go through changes over time, these changes become influenced by both the supply of money available to loan and the demand from those seeking to borrow money. Perhaps one of the easiest ways to think of interest rates is to call it the price of money. Individuals and businesses borrow money when they do not have the cash on hand to make a purchase; the lender considers interest as the price of lending their money to the borrower.

The percentage of interest charged to the borrower coincides with the level of risk the borrower has on repaying the loan. Larger loans come attached with a higher interest rate due to the increased risk of defaulting on the loan. However, there are other economic and policy factors which can affect the interest rate of various types of loans.

Economic Factors


Perhaps the single largest factor that determines interest rate changes is how much money a lender has to lend out. If the demand for loans outpaces the supply of money to lend then the lenders will raise their interest rates and likely have to borrow money themselves in the form of bonds.

Credit Markets

Credit markets across the board work in a similar fashion.  When the economy is riding a high, corporations may need to borrow in order to expand operations, secure inventory, or acquire other businesses. For the consumer, they will borrow money to buy homes, cars, etc. When the demand for cash remains high, it will in turn keep interest rates high.

Fiscal Policy

Fiscal policy simply refers to how a government manages its money to fund government programs such as education, defense, welfare, Medicaid, etc.  Federal governments sometimes borrow money when government spending outpaces tax income, this borrowing is referred to as deficit financing.   When a government borrows money and has very high expenditures it tends to create a problem for the general population to borrow money and can drastically affect interest rates.

Monetary Policy

Monetary policy is another central component to how interest rates can fluctuate.  A central bank will often alter the supply of money in an effort to control inflation and direct the economy.  When a central bank or federal reserve creates more money the interest rates tend to drop because more money is available to lend out to other institutions.


Inflation is yet another factor which influences and changes interest rates. Interest rates and inflation sort of go hand in hand.  When inflation is high, interest rates are also high.  Likewise when inflation is lower, interest rates are lower.  Most lenders will want to preserve their investment so when inflation is high they charge a higher interest rate and likewise when inflation is lower they relax the interest rates on loans.

It is important to understand how interest rates rise and fall if you plan to purchase a home in the future.  This even applies when you are looking at rent-to-own homes as you will eventually need a loan to purchase.